Beware the value trap in takeovers

Takeovers returned to centre stage in August, and more transactions are likely as deal makers point to a pick-up in corporate activity. But the positive sentiment generated is often misplaced for blue-chip investors as the expected lift in merger and acquisition (M&A) activity threatens to erode shareholder value.

Most takeovers fail to live up to expectations and this explains why the share price of the bidding company often falls following an acquisition announcement.

A number of international studies have shown that the bidder’s share price loses about 1 per cent of value on average in the day or two after the news and 6.5 per cent in the five years following the merger.

“Acquisitions do create value on average, but all of that value created goes to the target’s shareholders," said Melbourne Business School professor of strategy Paul Kerin.

Since the largest listed companies are more likely to be bidders than targets, investors should brace for the possibility of additional concerns while the global economic recovery remains fragile.

Celeste Funds Management chief investment officer Frank Villante noted that management teams often thought adding one with one would yield a result greater than two.

“There are some companies that are quite good at doing acquisitions to grow at a rate above organic growth rates, but they are in a minority," said Mr Villante, who estimates two-thirds of acquisitions destroyed or added no value for investors. “I think a lot of deals are done on ego and are not well thought out," he said.

Mr Villante noted that pulling off successful deals required specialised knowledge and left management in acquisitive companies with less time to run the business.

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While shareholders of a targeted company often enjoy a 20 to 30 per cent jump in the value of their shares, the impact on shareholders on the opposite side may be more painful, judging from some recent deals.

BHP Billiton
’s announcement this month that it is bidding for Potash Corporation of Saskatchewan sent its shares tumbling 4.4 per cent on the day local investors digested the news.
GrainCorp
’s attempted takeover of
AWB
at the end of July shaved 6.2 per cent off its share price on the day of the news,
National Australia Bank
’s declared interest in
AXA Asia Pacific
resulted in its share price slumping 4.7 per cent in December last year and
Seven Group
Holdings slid 5.2 per cent on February 22 when it revealed plans to merge with WesTrac Group.

Buoyed by BHP’s tilt at Potash, August was the second highest month for Australian M&A on record, according to Dealogic. Dealmakers expect activity in the latter part of the year will better a lacklustre first half, but no one predicts a quick return to boom times.

Still, more bids are likely to emerge as some large-cap companies feel the pressure to deliver growth to make up for disappointing sales in existing operations. Some corners of the market are of the view buying growth may be the easiest way out of this predicament. That argument is underpinned by the fact that Australian listed companies have emerged from the financial crisis with a cash horde of $157 billion, according to Bloomberg data.

Of this amount, close to 80 per cent resides on the balance sheets of the biggest 50 companies on our exchange.

These market giants can also easily access other sources of funding – such as the US and European bond markets where highly rated companies can get extra capital at low yields due to the exceptionally low interest rates set by central bankers in those countries and the strong appetite for non-government and non-financial debt.

What may enhance shareholder value is a special dividend or other capital return initiatives.
Woolworths
’s $700 million share buyback is one example, with the stock jumping 3.5 per cent in two days following the news and its pleasing full-year earnings result.

But that’s not to say M&A doesn’t yield results, as there are examples of companies that have increased shareholder wealth through takeovers. The trick is figuring out whether management knows how to buy smart.

Looking at the structure of the deal often gives a clue, according to the managing director of BlackRock Investment Management, Ken Liow.

“When a company is prepared to pay cash as opposed to scrip, that’s often a good statement," said Mr Liow.

Studies have shown that the market capitalisation of the combined entities following a cash deal grows by 14 per cent on average, while the market cap of the merged entity shrinks by 3 per cent in an all-scrip deal.

This could be because management teams offering cash in a hostile bid could be under greater pressure to justify the deal, and were less likely to overpay.

Mr Liow pointed out that management’s track record was very important. There are other rules of thumb that investors could use, according to Professor Kerin.

“The more related the businesses are, the bigger the value creation. But by related, I mean if there are real synergies to be had or where the acquirer can directly add value."

He believes shareholders should always be sceptical of what the company says because boards will always try to sell the merits of the deal, but the reality is these synergies are often not there or are smaller than projected. Foster’s Group’s foray into wine is a classic example.

A good acquisition is an exception and not the rule, and Professor Kerin doesn’t think that any of the recent deals announced, including BHP’s bid for Potash Corp, satisfies the conditions that make a good acquisition.

Research drawn on by Professor Kerin suggests the real value for investors is perhaps looking for demerger candidates, as spin-offs more often than not create value.

Orica
selling
Dulux
and
CSR
’s sale of Sucrogen are two recent examples, and he highlights
Wesfarmers
as a potential candidate that could unlock a lot of value if it split its disparate businesses.